The euro: like it or lump it

Barry Eichengreen has a post on Voxeu about how difficult it would be for a country to make an orderly exit from the euro. (The column draws on a longer NBER working paper.) The strength of the euro is squeezing Europe, and especially Italy, very hard. There is some talk of pulling out of the euro system. If only. Italy would surely benefit if it could. But, as Eichengreen explains, it literally cannot without precipitating a really fearsome financial crisis.

In 1998, the founding members of the euro-area agreed to lock theirexchange rates at the then-prevailing levels. This effectively ruledout depressing national currencies in order to steal a competitiveadvantage in the interval prior to the move to full monetary union in1999. In contrast, if a participating member state now decided to leavethe euro area, no such precommitment would be possible. The verymotivation for leaving would be to change the parity. And pressure fromother member states would be ineffective by definition.

Market participants would be aware of this fact. Households andfirms anticipating that domestic deposits would be redenominated intothe lira, which would then lose value against the euro, would shifttheir deposits to other euro-area banks. A system-wide bank run wouldfollow. Investors anticipating that their claims on the Italiangovernment would be redenominated into lira would shift into claims onother euro-area governments, leading to a bond-market crisis. If theprecipitating factor was parliamentary debate over abandoning the lira,it would be unlikely that the ECB would provide extensivelender-of-last-resort support. And if the government was already in aweak fiscal position, it would not be able to borrow to bail out thebanks and buy back its debt. This would be the mother of all financialcrises.

What government invested in its own survival would contemplate thisoption? The implication is that as soon as discussions of leaving theeuro area become serious, it is those discussions, and not the areaitself, that will end.

A cynic's instinct would be to say that scholarly articles explaining why the euro system cannot break up mark the beginning of the end--but Eichengreen's logic seems impeccable. Italy would surely have been better off if it had never joined the system (an isssue Eichengreen does not go into here), but it is too late for regrets now. The title of the column is the only mistake I can see. "The euro: love it or leave it?" That surely ought to be: "The euro: like it or lump it [no question mark]."